A convertible issue is a bond or a share of preferred stock that can be converted at the option of the holder into common stock of the same company. Once converted into common stock, the stock cannot be exchanged again for bonds or preferred stock. Issue of convertible preference shares and convertible debentures are called convertible issues. The convertible preference shares and convertible debentures are converted into equity shares. The ratio of exchange between the convertible issues and the equity shares can be stated in terms of either a conversion price or a conversion ratio.
- Convertible Preference Shares: The preference shares which carry the right of conversion into equity shares within a specified period, are called convertible preference shares. The issue of convertible preference shares must be duly authorized by the articles of association of the company.
- Convertible Debentures: Convertible debentures provide an option to holders to convert them into equity shares during a specified period at particular price. The convertible debentures are not likely to have a good investment appeal, as the rate of interest for convertible debentures is lesser than the non-convertible debentures. Convertible debentures help a company to sell future issue of equity shares at a price higher than the price at which the company’s equity shares may be selling when the convertible, debentures are issued by convertible debentures, a company gets relatively cheaper financial resource for business growth. Debenture interest constitutes tax deductible expenses. So, till the debentures are converted, the company gets a tax advantage. From the investors point of view convertible debentures prove an ideal combination of high yield, low risk and potential capital appreciation.
Significance of Convertible Issues
The convertible security provides the investor with a fixed return from a bond (debenture) or with a specified dividend from preferred stock (preference shares). In addition, the investor gets an option to convert the security (convertible debentures or preference shares) into equity shares and thereby participates in the possibility of capital gains associated with, being a residual claimant of the company. At the time of issue, the convertible security will be priced higher than its conversion value. The difference between the issue price and the conversion value is known as conversion premium. The convertible facility provides a measure of flexibility to the capital structure of, the company to the company which wants a debt capital to short with, but market wants equity. So, convertible issues add sweeteners to sell debt securities to the market which want equity issues.